Audit

What Is An Audit?

An audit is the process of procuring, examining, investigating, and evaluating the financial statements of an economic entity (i.e., company), which are aimed at checking for accuracy, true and fair presentation, and compliance with the prevailing standards and regulations.

This ensures the subject company's financial statements are free from material misstatements or corporate bias and that the financial statements of the company represent the financial health of the company accurately.

The audit is a systematic and independent examination of financial information to provide an opinion on its reliability, accuracy, and adherence to accounting standards.

The element of an audit (investigation) is done on different aspects of our day-to-day life without even realizing it, such as a parent checking his/her child’s homework or a report card. 

However, the audit in this article focuses on the mandatory professional-level comprehensive compliance check aiming to provide an independent opinion on the fairness of financial statements and the company's compliance with relevant laws and regulations. 

These audits are typically conducted by qualified audit professionals who follow prevailing accounting and auditing standards, such as Generally Accepted Auditing Standards (GAAS - US) or International Standards on Auditing (ISA - international).  

The ultimate output of an audit is the audit report and the auditor’s opinion. This is what ensures a reasonable assurance to the shareholders and other stakeholders regarding the company's fair and accurate reporting of the economic situation being in a true and fair position.

Why Do We Need An Audit?

The ultimate aim for a company to indulge in an audit is to obtain the auditor’s opinion and the audit report. These are what ensure a reasonable assurance to the shareholders and other stakeholders that the subject company's economic position is reported to be truly and fairly presented.

Many users rely on external independent reviews of the company to preserve trust in the entity in maximizing the investments correctly, making an audit report an essential component of a company's annual report. 

A broad classification of the users who rely on the audit report is as follows:

1. Shareholders
2. Potential Investors
3. Suppliers 
4. Tax Authorities
5. Banks/Financial Institutions 
6. Other Stakeholders, such as customers and employees.

It becomes crucial when it comes to the Tax Authorities, who try to maximize investor safety and minimize fraud. It is a matter of time before such audits become statutory when the company passes a certain threshold. So, better get used to it. 

“So what are the benefits?” You say. Well, an audit:

• Increases the credibility of the financial statements.
• Protects the interests of minority shareholders. 
• Target weaknesses within the organizations and suggest remedial actions.
• Ensures compliance with the prevailing rules and regulations. 
• Detect and prevent any fraudulent activities. 
• Offer recommendations on the improvement of the existing system in place, which leads to cost cuts and improved business operations.

Elements Of An Audit

With the practical constraints impending upon the audit team, it is vital to indulge in an audit that has a proper procedure to obtain reasonable assurance that the financial statements are true and fair. 

True and fair does not mean it is correct, totally accurate, or error-free. Instead, it is based upon verifiable evidence and is free from material misstatements (true), along with objective presentation, free from management bias, and user relevance (fair).

To execute a successful audit,  five elements need to be successfully incorporated. These elements are drivers of a well-executed audit; they are:

1. Objectives: Understanding the audit's objectivity creates a clear pathway to conduct an effective audit.
2. Scope and Procedures: Understanding the scope and the required procedures to perform the audit facilitates allocating necessary audit resources.
3. Findings and Conclusions: Drawing conclusions based on the obtained evidence allows the auditor to express an audit opinion confidently. 
4. Recommendations and Suggestions: From the obtained conclusions, any identified issues should be communicated with the management for further remedial strategies to overcome the weaknesses. 
5. Management’s response: Understanding the legitimacy of the management by observing the management’s action on implementing the remedial actions suggested by the auditor.

Nature Of An Audit

Audits happen in every shape and form. Each audit is different since its objectives and outcomes serve different purposes for an entity. It is crucial to be able to understand what audits benefit who and are required by whom.  

If one needs to understand which audit to pursue, it is a waste of time and resources, especially when many types of audits are required for a company. But broadly, there are two natures for an audit:

1. Statutory Audits: Statutory audits are required by law due to a prevailing statute. These audits are mandatory for the targeted companies, typically public companies, to show their business performance is lawful by checking the credibility of their financial statements.  
2. Non-Statutory Audits: These are not required or mandated by law. Companies can voluntarily carry out audits of their financial statements for any special reason, such as additional borrowing from banks or lenders.

Types Of An Audit

Now, setting aside the broader nature of an audit, let's dive into different types a company can indulge in. Some of the types are explained below. 

Internal Audits

These are audits that the company conducts. This mainly checks whether the implemented internal controls are working efficiently or not and whether any weaknesses are present within the control. 

Internal audits are performed by internal auditors, who are company employees. Therefore, they report to the manager or the company Board. The insights procured by the internal auditors are then considered, and the management takes remedial action. 

External Audits

These are conducted by an external independent entity typical of an audit firm. External auditors perform audits on the subject company to attain relevant audit evidence to support their audit opinion on the financial statements’ true and fair nature. 

The shareholders or audit committee appoints these external auditors on behalf of the shareholders; therefore, external auditors report directly to the shareholders. This article mainly focuses on this type of audit.

Tax Authority Audit

These are conducted by the Tax authorities of the country where the business is operating, such as IRCC (Canada), HMRC (UK), and IRS (USA). 

These audits are typically seen in a negative light, especially since the tax authorities conduct audits when they suspect any fraudulent activity by observing the tax returns and presented documents.

There can be audits done by higher authorities to diminish corruption among the authorities, such as the Supreme Audit Institution (SAI), a UAE-based higher audit institution that audits governmental and federal institutions such as the Ministries.

How Audits Are Conducted?

An auditor is a professional who conducts an audit process for the company by investigating, examining, and evaluating the financial statements of the subject entity to express an audit opinion on the nature of the statements.

Normally when an external audit is conducted, an audit firm is selected via a tendering process, i.e., choosing the best value external auditors having the best audit expertise and are independent of the subject firm. 

There are limitations on the professionals who audit. Auditors are one of the regulated professions around the world, and there are consequences to actions taken. Therefore, their procedures will be of utmost professional skepticism and ethical standards.

After the selection of the external auditors by the shareholder, the audit firm then starts planning and allocating resources for the audit of the client company. 

From the initial setting stage of an audit to the reporting stage, an audit firm needs to complete the audit using the available time and resources. The overall auditing of a company is completed in four phases.

Planning Phase 

The planning phase pertains to the audit team understanding the full picture by acquiring the details regarding the entity and analyzing the necessities before tackling any audit procedures to ensure a precise flow of audit procedures.  

The Planning phase is usually undertaken in two stages:

1. Audit Strategy: Under this stage, the audit team defines the scope of the audit along with the required timing to complete it and sets a direction for the team to follow to maintain efficiency during an audit. 
2. Audit Planning: During this stage, the audit team defines the nature, timing, and extent of the available resources and the procedures to conduct an effective company audit.

Processing Phase 

Under this phase, the auditors gather vital information about the company, such as financial records necessary to perform an audit. This information poses as an instrument to evaluate financial statement accuracy. 

Testing Phase 

Under this phase is where the actual audit occurs. The auditor tests the received information on various tests such as Test of Controls and Substantive tests to ensure the accuracy of the information using revaluation or third-party support.

Reporting Phase 

This phase signifies the end. During the reporting phase, the auditor ensures reasonable assurance by expressing his/her opinion regarding the company’s financial statements in the audit report, whether it is True and Fair manner or not, using audit evidence. 

In the audit report, there can be 4 types of audit opinions. They are: 

1. Unqualified opinion (Unmodified)

The qualified opinion expresses the auditor's satisfaction with the financial reporting of the financial statements that are shown to be true and fair. This is the result every company aims to achieve from their audits.  

2. Qualified opinion (Modified)

The qualified opinion expresses that the auditor has identified certain limitations or exceptions in the financial statements, such as lack of evidence or audit procedure restrictions that, in their judgment, do not materially affect the overall fairness of the financial statements. 

A qualified conclusion doesn’t make the company “fraudulent” per se; rather, the auditors are not fully satisfied with the company's audit results.

3. Adverse opinion

The adverse opinion expresses that the auditor does not trust the company’s controls and compliance on financial reporting and suspects any fraudulent activities that can lead to future lawsuits.  From here on, it's the danger zone.

An adverse opinion shows the auditor being skeptical of the company's procedures and suspects activities of fraud by the management, leading to losing confidence in reasonably assuring the company’s financial health.  

4. Disclaimer opinion

The disclaimer opinion expresses that the audit was not able to be conducted properly due to the lack of required documents and lack of cooperation from the company’s management.

Reaching this stage is the dark side; the auditor does not trust the company at all, and to protect himself/herself from potential harm, professionally resigns from further conducting the audit.

Duration Of An Audit

Audits are extensive and are not tasks that just involve checking and authorizing. An audit of an enterprise lasts over the accounting period of that enterprise. 

However, it is not feasible when the audit is conducted that long, especially since the company may need the auditor’s opinion on their statements either to publish on time or to get approval from the bank or lender for a loan to expand the business. 

Nor is it reasonable to shareholders for auditing for a short period when there is a window for any fraudulent activity after the audit completion. So what is the solution? Intervals are the solution to this situation. An audit has two intervals across an auditing period. 

1. Interim audits: These are those performed on a preliminary basis before the actual year-end of the entity. These audit periods can range from 6 to 9 months. 
2. Final audit: These are those audits conducted on a final basis considering the factors involved after the interim audit as well as the publication of the financial statement.

The Big Players In The Field Of Audit And Assurance

In the audit and assurance field, some giants dominate on the global stage. These companies offer audit and assurance services and non-audit services such as consultancy while taking steps to maintain independence. 

Below are 10 such companies that are world-renowned for their services. 

1. PricewaterhouseCoopers (PwC)
2. Deloitte 
3. Ernst and Young (EY)
4. Klynveld Peat Marwick Goerdeler (KPMG)
5. Grant Thornton 
6. BDO 
7. Baker Tilly
8. HLB
9. Crowe Horwath 
10. RSM

Researched and authored By Muhammed Ishfaque Ishaque | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Forensic Audit Guide

• Fraud In Audits

• How To Prepare For An Audit

• Legal Importance Of An Audit

• Materiality Threshold In Audits